Is Economic Ignorance Bliss for Real Estate Investors?

I was the featured speaker at my local real estate club a few days ago. There was a good turnout with the typical mix of novice, moderately experienced, and well-seasoned investors. Before beginning my presentation on evaluating rehab properties, I provided a brief update on a fairly significant economic event that would happen at the end of June. Much to my surprise, not a single person in the room knew about it.

It’s understandable that neophyte investors weren’t aware of it, but even those with decades of experience had no clue as to what I was talking about. When I asked the audience if anyone knew what QE2 was a few people responded that it was a ship. When I mentioned that it was a Federal Reserve strategy designed to stimulate the economy I was met with blank stares. QE2 is the acronym for Quantitative Easing round 2 and it ends on June 30th. Experts disagree on the magnitude, but its end will impact just about every investment vehicle in some way, including real estate.

This role of managing the economy through the money supply is achieved by the use of three primary tools. The most well-known is setting interest rates for Federal Funds. With that rate currently near zero that option is off the table. Another weapon is setting reserve requirements for banks. That is the amount of money banks are required to hold in reserve for each dollar on deposit. Current reserve requirements don’t allow much manipulation at the moment. That leaves one arrow remaining in the quiver – open market operations. This is the buying and selling of US Treasury bonds, bills, and notes on the open market to increase or decrease the amount of money in circulation.

Even if you live in a cave on a remote island in the South Pacific you know that the US Government has been running massive, trillion dollar deficits. Those deficits are funded through the sale of government bonds, bills, and notes. What you may not know is who is buying those debt securities. Why, it’s none other than the Federal Reserve. That’s QE2. In a nutshell, the government has been printing money and backing it with nothing more than a bookkeeping entry on the nation’s balance sheet. The policy can’t continue indefinitely and that’s why it’s ending. But who is going to buy the bonds we are now buying from ourselves?

Raise Your Awareness

The recent real estate bubble was, in hindsight, unsustainable. When it burst a great many people were caught with their pants down and hurt financially. The warning signs were there but people were oblivious to them. That is often the case with major economic events. People tend to focus on their immediate surroundings and pay no attention to the big picture. That ignorance may be fatal to your bottom line.

Some experts say the effect of QE2’s demise will be minimal and others insist that it will have broad implications. (WSJ Bog) Common sense suggests that interest rates will have to rise. If the supply of bonds increases the price will have to drop to attract buyers. As bond prices fall, interest rates rise. How far and how fast rates rise will impact the buying power of anyone using financing to secure investments or buy goods.

Am I suggesting that it’s time to panic? Not at all. However, you do need to pay attention to the overall economy since we are all a part of it. The supply of bonds could be reduced to keep prices up but that would mean that the government has to stop spending so much money that it just doesn’t have. While we’re at it, hell could freeze over, pigs could fly, and Elvis could make a comeback.

The government solution to a problem is usually as bad as the problem. – Milton Friedman

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7 Comments

Hey Richard — The follow-up question might be how many actually believe there won’t be QE3, regardless of what they choose to call it. In my opinion they won’t stop, as they have no choice from their point of view.

I think they’ve painted themselves in a corner here. Bernanke has adamantly stated that it will not continue. It may turn out to be like a smoker trying to quit cold-turkey. They’ll stop it and see how the markets react, if they don’t like what they see they may quietly reinstate the program. If the market keeps tanking like it has been lately it may have to keep going.

Bernanke is scared silly about deflation. In my opinion the first responses to the cessation of QE2 will be deflation-like. Uncle Ben will then go back to QE, but won’t call it that. It’s very predictable in my opinion.

QE 1 & 2 were not money printing but rather an asset swap function. This allowed for easier conversions from one asset type to another which allowed for more dollars to be in play with investments based in the Dollar. If Bernanke understands what he is doing he will not start another round of QE. Their will be initial shock and some weakness in several areas that are easy to speculate in with an easy money policy. Once the fear subsides and people realize that the Treasury Bond rates will not explode, normalcy will return and confidence will also grow in the markets as artificial supports are removed.

As for mortgage rates, they will rise as they will revert to mean over time but this will not be overnight either and I don’t believe will be for several years. Banks are one of the largest buyers of US treasuries as a function of monitizing equity, not debt as many QE commentators seem to think. If investors in real estate follow their due diligence and study their field I still have great confidence in the real estate market and its chance for profit.

Richard – I like the piece in that is shows that the average person does not follow highly technical but also highly important events related to their field of work. Staying up on current trends in real estate investing is hard enough but to truly succeed we also need to have a good grasp of what is going on on the periphery of our world as well.

That being said I’m afraid I’ll have to disagree with you on your explaination of QE2, some parts at least. You stated that the treasuries fund government operations. This is not true, at least officially for the last 4 decades since we came off the gold standard and now operate a modern fiat currency system. The federal government is the monopoly supplier of our currency, not a currency user like those countries in the EU. The states, businesses, and individuals are currency users but the federal government is not, thus different rules apply. A great site to further understand this is pragcap.com. This isn’t just nit picking, but actually has a practical purpose, as this understanding has helped me become a more confident investor at this time. Look at the Fed’s bond auctions and see that they are consistently oversubscribed 3 fold at bargain basement interest rates. Look at Japan, who also is the monopoly supplier of thei currency the yen, they have debt to GDP over 200% and can still sell bonds at low low interest rates. You touched on the accounting functions of the feds purchases in QE2, I believe that after following this through further you will see the same way I do and have much more confidence in our economic future, at least in some respects.

Good day and great article showing that knowledge is power and their is always more knowlege to be had and the great thing is its free!!!

“The policy can’t continue indefinitely and that’s why it’s ending.”
well no, it can’t continue indefinitely. however qe2 is ending and now the recovery is sputtering… considering the minimal costs and considerable benefits associated with qe2 it doesn’t seem like we should stop now
“But who is going to buy the bonds we are now buying from ourselves?”
really? these are us treasury bonds. generally considered the most liquid of all assets. even now, after qe2, bond yields are incredibly low. all the data indicate we are in no danger of seeing them rise. where are your invisible bond vigilantes??

And now the recovery is sputtering? The recovery has been weak all along, it has nothing to do with QE2 ending.

“these are us treasury bonds. generally considered the most liquid of all assets”

Well, yeah. But that doesn’t make them exempt from the laws of supply and demand. QE2 has artificially reduced supply by taking a huge amount of bonds off the market. With QE2 ending someone has to buy those bonds. Who will is a legitimate question, it’s not a suggestion that no one will want them, quite the contrary. However, a large supply will result in lower prices. Lower prices equal higher yields, that’s simply economics 101.

“considering the minimal costs and considerable benefits associated with qe2 it doesn’t seem like we should stop now”

Minimal cost? There is a huge long-term cost here. If the cost is so minimal why is Bernanke adamant that the program will not be continued?

“even now, after qe2, bond yields are incredibly low”

We’re still in QE2, it’s not after QE2 as you say. The reason rates are low is because QE2 is taking much of the supply off the market. Again, refer to economics 101 and the law of supply and demand.

“all the data indicate we are in no danger of seeing them rise”

Love to know what “data” you are referring to. If we are in no danger of seeing them rise why are so many bond mutual funds sharply reducing their treasury holdings?

“where are your invisible bond vigilantes??”

Bond vigilantes? I don’t understand the logic in this statement at all. Suggesting that investors pay attention to basic economics and related events somehow equates to bond vigilantes? Ludicrous.